Beware the Hot Money!

It's obvious China's currency numbers aren't correct, so what does that mean for traders?

If we were to look out into the market to try and identify if there are any warnings or any dark clouds on the horizon, anything we might want to keep our eyes on for the near-term that could spoil the rally as we head up to the high 1600s on the S&P 500, and there is.

It’s the Chinese currency. We have a problem. Just to put it in perspective, recently China announced it had a trade balance report. It was much better than expected, and that was, in and of itself, not that uncommon, but in this case, it’s just completely not matching up with what anybody else is reporting. Now, Chinese economic data is not reliable generally, but it’s usually within the ballpark. They tweak their numbers, so it’s not usually very reliable, but it’s not usually this far off, either. It’s obvious it’s not correct.

What’s happening is a phenomenon called “hot money.” Hot money is how we describe money that is moving from one economy, or from one country, to the other in search of short-term profits. The reason why it’s called hot money – and the reason why it’s a bad thing – is that it moves in and out of an economy very quickly, so that can cause significant disruptions, instability and things like that.

In the video, I show you a chart of the Chinese currency, the yuan. China doesn’t free float its currency – nobody really does – but they really don’t free float their currency. They manage it on the way down. The reason why this is trending down is that the yuan is naturally appreciating in value compared to the U.S. dollar, so it goes down because it takes fewer yuan to buy a U.S. dollar right now.

In China, there are a bunch of investors and business owners that they see this trend and they say, “I want to buy yuan, and I want to sell, or short, other currencies.”

If you’re in China, you can’t just do that. It’s not like if you’re in the U.S. or western Europe or a variety of other places. There are restrictions on being able to do that, but if you’re an exporter, you can – if you fake an invoice.

I’m really over-simplfying things, but let’s say you have an invoice that says, “I sold $5 million worth or product to the U.S.,” so you’ve got your invoice and you borrow $5 million on the down low, and you go to the bank and you say, “I’ve got to exchange my $5 million U.S. dollars into yuan.”

They say sure, so they take the $5 million and they give you $5 million worth of yuan, and then you just sit on that, knowing that this trend is outrageously positive into my favor. The lower this thing drops, that yuan is basically getting more and more valuable. So, that is the definition of hot money. In this case, it’s driven by a lot of domestic speculators in China.

Now, take our fictional speculator who has faked an invoice, multiply that by a lot, and you basically get this situation where everybody is reporting Chinese numbers that are really low for exports and, yet, China is reporting really high numbers. What this is saying is this – while we might be able to debate the terms – this fraud is really wide-spread.

So, there are inflated numbers that nobody knows what they are for sure, and we’re all trying to get a handle on what it is. It’s not panic mode yet, but it definitely is something that we want to keeping our eye on.

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